Incentives Matter:

Incentives Matter:

Canada’s productivity performance is not just bad; on the whole it has been getting worse.

Our labour productivity since 2000 has deteriorated compared to both our own performance in the latter half of the 1990s and to American performances since 2000. In both cases our performance since 2000 has been one third of these two benchmarks. The productivity gap between Canada and the US has gone from 17 percentage points to 26.The effects of the recession on productivity are not yet clear, but there isn’t much evidence yet that it has changed anything fundamental except that some productivity gains in the financial sector may have proven to be illusory. If anything, the experience in the United States is that because of their flexible labour markets, they come out of recessions with productivity enhanced.

This Commentary, based on remarks by AIMS senior fellow Brian Lee Crowley shows that this is relevant to transfers for two reasons. First inter-regional transfers such as equalization and regionally-enhanced EI benefits are entrenching low-productivity performance in recipient regions while driving up costs in higher productivity regions. Second, because the federal transfers blunt the incentives for productivity improvements in many provincially-delivered services, we are helping to entrench higher than necessary taxes to pay for wastefully delivered services.

And while transfers such as equalization are often justified on the grounds that they protect the equality of Canadians in their access to provincial services, that is less and less convincing when we see how equalization has in fact been used. I has been used not to guarantee equal levels of services, but to guarantee, for instance, relative levels of provincial government employment and pay in the recipient provinces that exceed those offered in Ontario and Alberta.

That is the classic outcome of rent-seekers scrambling to capture the spoils that transfers have put on the table. That no doubt helps to explain why Ontario has roughly 75 municipal and provincial public servants per 1000 population, while Newfoundland has 99 and Manitoba comes top of the league with 108. These differences are far greater than can be explained by mere economies of scale, and help to explain why there is increasingly among the think tank community a sense that Canada over-equalizes and that this is damaging both those who foot the bill and those who get the transfers.

The damage to recipients will only be exacerbated in a time of demographic change and tight labour markets, as transfers help to make provincial governments formidable competitors for available labour in local provincial markets. In recipient provinces, public sector wages often tend to be higher compared to local average wages than in richer provinces.

In this talk to the Federal-Provincial Relations division of Finance Canada, Crowley explores the above examples of how incentives truly do matter. He also highlights that, while government has more consistently gotten the incentives wrong, it can just as easily get them right. He highlights welfare reform as one such example:

Provincial welfare reform highlights the power of decentralized delivery of government services and the varied and innovative approaches different provinces took to improve their welfare and related programs. The results of these reforms were dramatic. By 2000, the number of welfare beneficiaries in Canada had declined to a little over 2 million (6.8 percent of the population) from a peak of 3.1 million (10.7 percent of the population).[2] In addition, welfare-related spending had been curtailed, helping governments to balance their budgets. Most importantly, however, the programs being delivered seemed to be achieving better results by getting more employable individuals into the job market and dealing with some of the more pressing underlying problems that caused people to consider welfare as an alternative to work. My view is that these reforms would not have occurred without transfer reform at the federal level, reforms that changed fundamentally the incentives for provincial governments by making them much more accountable for their spending decisions and the consequences of poor programme design.

To read more on how government might use this success to change other flawed incentives,click here.